ECB Eases (Mea Culpa): Merely Reflation, but More Coming?

My pro-Euro dissolution argument heavily weighed the bifurcation of EU-17 economies, with Germany at the top and Greece at the bottom. I reasoned that monetization a la US Treasury/Fed was not a viable solution for Europe, because printing Euros to fill the holes in Greece’s balance sheet–then the other PIIGS sequentially–would trigger [fears of] haunting inflation in an otherwise viable German economy. Further, I reasoned that Europe might attempt monetization, but she wouldn’t ultimately follow-through, due to the power consolidated in Germany. The outcome remains to be seen, yet the half-measures already enacted (specifically LTRO) have surprised me in their boldness–unilateral decisions for the fact they evade Germany’s local legal process. Originally, my hypothesis said ‘they shouldn’t, and they wouldn’t.’ They still shouldn’t, and they still won’t follow through. Sorting through the rubble to take an inventory, I’m using this entry as a thought piece to consider where Europe stands.

It’s not as simple as Germany putting up capital to paper over the Eurozone’s fringe. Let us not lose sight of the cause/effect, the give/take. Inflation is the backlash, just like it was when ERM I dissolved on Black Wednesday. France just reported the highest inflation in three years, an annualized 2.4% in August. The core is experiencing inflation levels at or above highs in the history of the currency bloc (1999-present). This occurred despite the ECB having raised interest rates twice recently. At the heart of the dilemma in Europe is the bifurcation of the EMU constituents. They raised rates (for God’s sake) in the middle of a crisis to stop inflation in the core.

Regarding the veracity of “bifurcated” Euro economies, I perhaps ignored evidence to the contrary. The issue of German vendor finance has European economies more interwoven than anyone expected. (Most pundits still haven’t even discovered this.) Somehow, I underestimated the effect, even though I was one of the first to call attention to it:

German exporters were able to start financing the purchase of their goods by foreign importers, particularly to defer payment when the latter (deficit countries) grew bloated & cash flow poor. This kept Germans employed, factories bustling, and the national surplus mounting. In this way, Germany has entangled the Euro nations. Her AAA credit rating really should be called into question. Germany is just a giant shell, a conduit, a SIV through which debtors’ cashflows circulate. A SIV’s integrity is really the integrity of the underlying credit it holds.

To an extent otherwise unimaginable, the story of German vendor finance tethers a seemingly “viable German economy” to the broader Eurozone. Among policymakers, I’m noticing a conventional wisdom increasingly supportive of monetization as a boon for German interest. I’m convinced the recognition of EU interdependence stoked this movement, an attempt to salvage a swath of $1.2T annual German exports. Such conventional wisdom is not shocking, as it’s the Keynesian root of latter day economics. However, it is folly, and I’m shocked nobody has abandon these roots. Like I keep saying, it’s a “6 cents or one-half dozen” scenario. Whether Germans/creditors receive payment in devalued drachmas, inflated Euros or revalued marks, it all has the same real value. A pound of feathers weighs the same as a pound of rocks.

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I previously suggested that the greatest impact of this de facto Eurozone homogeneity was the transfer of bargaining leverage to Greece’s corner. Were it not for Germany’s leveraged exposure to PIIGS credit, the Germans would twist the knife of austerity. [See: Ireland.] Yet, whenever a creditor finds herself over-exposed to a flailing debtor, clout always resides with the latter–contrary to the rythm of financial contracts. With Greece enabled to call her own shots, I still think they prefer reversion to the drachma over indentured servitude. That is, the people prefer it; the Manchurian technocrats now in control have a converse agenda to appease the troika. That’s the interesting crossroad at which we’ve arrived, the determinant as to whether or not Europe follows-through with monetization. Who holds the bargaining leverage: the politicos who’re synonymous with the EMU edifice, or the realists who’re partisan only to the best outcome?

Pointing to the creditors at the Private Sector Involvement (PSI) negotiations in Athens, I suggest the realists are in control. These creditors are reverting the Greek market to its fundamental attractor, a locus toward which all markets are eventually drawn by the laws of gravity. (The EMU’s machinations denied this natural reversion for so long.)

These are the hedge funds and institutional investors at the table. They are not the sovereigns (like Italy or Germany). Like I said, the Germanys of the world are overexposed to Greece. They’re more of a catcher than a pitcher in negotiations. The hedge funds, on the other hand, are not price takers, but price dictators. Greece is required to rear a voluntary PSI agreement with all creditors to skirt a “hard default.” They need the consent of hedge funds, but hedge funds don’t need to consent. Now that the time for decisive action has arrived, warring opinion has gone from troublingly binary to alarmingly fragmented in both Greece’s PSI negotiations and Germany’s anti-bailout policy. Germany’s official posture still extols an anti-bailout/inflation-fearing hardline, but dissenters are roaring from their lairs. (As aforementioned, the Keynesian kneejerk is everyone’s emergency reflex.) Despite her continued vocal insistence, Angela Merkel has compromised this populist hardline in the past (2009), and she seems to be cowering again in 2012.

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While national policymakers squabble, half-measures have been enacted by independent entities like the ECB. Consider the Long Term Refinancing Operations (LTRO), for example. Either German politicians’ abhorrance of monetization & bailouts is window-dressing to satiate public opinion, or Germany doesn’t have the clout to extract its pound-of-flesh from the countries it rescues. I say that because programs like the LTRO are a bailout mechanism; they’re straight monetization. Or, take another example: unlimited Fed swap lines, which hold over $84B in balances; they’re the backdoor QE3 of which I warned.

Yves Smith recently cited German sources, who assert: “…while the ECB is clearly willing to do more than in the past, it is not willing to balloon its balance sheet to the degree the Fed did.” To wit, I replied with a realist’s take:

I’m sure you all know this by now, but: ECB’s balance sheet ($3.2T) is not only far greater than the Fed ($2.9T), but at 30x leverage it has the same risk as Lehman. A major distinction is that the Fed has been forced transparent, while the ECB is fully opaque about asset quality. The ballooning has happened and continues to happen. There was a period of net deflation triggered by mark-to-market events, whence asset liquidation (MTM losses) outran printing on a net basis. That occurred from early October up until XMas–full stride in December (around LTRO).

The balance sheet needs to expand even more though, and I don’t think such earnest inflation is sustainable in the long term. I’ve continually referenced the Gold market as evidence of the shift from net deflation to monetization, and that hasn’t changed:

Gold

Bottom line is that we’re undergoing reflation (again). That’s bullish for risk assets, as a rising tide lifts all boats… regardless of valuation or outlook.